Enterprise Software CEOs Need a Dose of “Undercover Boss”

Connecting with the Disrupted Customer

What if enterprise software company CEOs were asked to do what other CEOs are doing on the TV show "Undercover Boss": to do the heavy lifting that their employees are doing every day? (It always makes me smile when I imagine Larry Ellison trying to write SQL.)

I think we'd find that there are very few software CEOs who appreciate what’s involved in developing or deploying their technology into the hands of customers. (Jim Goodnight at SAS may be a notable exception).

Most software CEOs can probably do what the average enterprise software salespeople do:  sit in meetings, make phone calls, and invent new PowerPoint charts.  But how many could actually put their hands on a keyboard and write code? Or even just configure their company’s products in order to create value for their end-users?  Although watching people – even great engineers – write code and run build-scripts isn’t quite the same as watching some executive load a garbage truck with dirty diapers during primetime.  

Obviously, I am having some fun here: programming is probably not required for running a multi-million-dollar or billion-dollar software company. But I'd go as far as to say that it's highly desirable for the CEO of a software company to understand the engineering of her/his company's technology.  Furthermore, knowing your customers (mostly engineers) and their needs is absolutely a requirement.  And, in general, it’s often incredible to me how disconnected many technology company executives are from what their products actually do for their customers’ end-users.

With the rapid maturation of the enterprise software industry over the past 10 to 15 years, the “nobody ever got fired for buying IBM” excuse is going away.  When buying enterprise software, customers today have many options and often radically reduced switching costs. They also have the ongoing pressure to improve efficiency of both capital and operating costs.

Meanwhile, corporate end-users are asking themselves and their managements: “Why can’t the systems that I use at work be as easy to use, simple and productive as the systems I use at home?”

Good question.  If your company has decided to use Google Enterprise Apps, you have an advantage. The capabilities you have from Google will improve at the pace that technology moves on the consumer Internet – not at the pace that your internal IT organization moves.  Many users who are frustrated with their captive IT organizations just pull out their AMEX cards and pay for cloud-based services that do the job without involving requiring a call to anyone in IT.  This is how Salesforce.com got its start and how systems such as Expensify today are replacing traditional enterprise expense management tools.  (Expensify has the best tag line in the world, in my opinion: “Expense reports that don’t suck!”)

If you work for a traditional enterprise software company, the consumerization of IT should be a huge wake-up call. If you are the CEO of one of those companies, I'd suggest embracing a model other than "milk my customers for maintenance revenue."

Even if you don’t expect a software company CEO to write code on national TV, it’s a good idea for her/him to get together with end-users who are actually using the software (or, more worrisome, not using it).  Then, he/she will have direct information on how good (or how bad) the software actually is and can make the decisions necessary to fix it quickly if necessary.  Start-up CEOs have the advantage of being closer to their customers, for both constructive feedback and complaints. A little start-up thinking could go a long way for most large enterprise software companies.

But I’d still like to to see the CEO of a large enterprise software company write some code ;)

Many Small Stock Grants Over Time Should Be the Rule in Start-Ups

An Alternate Approach

In my last post, I wrote about how important it is for founders to take a proactive and decisive approach to crafting their ownership models – to the extent of being a control freak about it.  Getting the correct ownership model in place up front is one of the more important decisions you will make as a founder, and it will guide you through key hiring decisions.  

And it doesn't matter how many or how few employees are involved* – it's still important. Do you grant stock up front to new employees? Or do you delay the grants (either through vesting or follow-on grants) over some period of time?  There are costs and benefits to various approaches, and many different mechanisms for executing any given approach.  Having a great start-up lawyer is key: the best folks I've ever worked with are Mitch Zuklie at Orrick and Marc Dupre at Gunderson.  

"Front-loading" stock options – granting large options up front to key employees – has been a popular approach in the past for many start-ups. But I've come to believe that a better approach is to give smaller stock grants up front (with relatively standard vesting of four years total with one-year cliff, then monthly for the last three years); followed by many small grants over time, at least annually but preferably every six months or so.  

When you grant options in this way, you essentially create a "ladder" of stock vesting that helps ensure that the rate of vesting for any given highly valued employee is going up consistently during that employee's first five to ten years at your company. 

Of course, you can always make exceptions, giving them a large up-front grant. However, I believe that such grants should be the significant exception rather than the rule.  

Here's my rationale.

How It Works and Why

With a laddered approach, you're focusing on the RATE of vesting, not the size of the initial grants, to increase the likelihood of retaining superstars over time.  Key employees who you want to reward and retain for the long haul enjoy an ever-increasing RATE of vesting: the number of options that vest each month or quarter after they pass their cliffs.  This also has the benefit of minimizing the impact of bad hires, who – assuming you are doing your job – will leave the organization before they vest too much and/or will not receive follow-on grants.  

The laddered approach has a powerful psychological impact on the employees. They're getting regular feedback on their performance. They FEEL appreciated on a regular basis and their efforts are recognized by the company through ownership, the most valuable form of compensation in mission-driven startups.  The sacrifices they are making are often “unnatural acts” of saying no to family, friends and personal comfort in the interest of doing “whatever it takes” to make a company successful.  Being recognized with more ownership over time, in my experience, means more to the average start-up employee than most investors can ever appreciate.

Another benefit of this approach is that it can protect you from a common pitfall: inadvertently selecting people who are great negotiators but perhaps not as good at actually doing the work and earning the stock.  For example, sales-oriented people tend to view the negotiation as an end in itself,  while engineers tend to view the work as what determines value and earns rewards.  By appealing to mission-driven people who know that there is more ownership available to those who perform, you'll attract people who are confident and willing to prove themselves and for whom the mission of the company is enough to get them on-board initially.  

Some Downsides

This approach does have some downsides. It can require a lot of administrative support and careful expectation-management so that employees don't expect both frequent grants AND large grants regardless of company and individual performance.  

Another potential downside is that the strike price of options or the purchase price of restricted stock increases over time.  So, the weighted average price for the individual is higher – sometimes dramatically higher during the first five years of a new company’s life cycle.  This can be especially hard if you are allowing your employees to exercise their stock early.  However, I suspect that most companies would be more than willing to compensate for this by granting a larger quantity of stock for the ultra-high performers.  It’s a net-positive-value decision to give top performers a disproportionate amount of stock.  The basis for their retention compensation is that they create more value than other people. Therefore, locking them in with more stock is equivalent to fundamentally increasing the value of the stock.

Ultimately, I believe that this approach actually costs the company less in the end. 

I believe that the practice of large initial stock grants is nothing more than an artifact – and one that doesn’t optimize growth for the company or the investors.   Let’s bury this practice once and for all and use it only as an exception not a rule.

* Except of course for the extreme case where no one gets any ownership other than the founder. If you are looking for examples of those, there are plenty - for example, Kenan Systems and Ab Initio in Boston or Trilogy in Austin.

Beware the "Accidental" Ownership Model

As a Founder, You are the Master of Your Domain

Over the past 20 years, I’ve participated in many start-ups, both bootstrapped and venture-backed.  During that time, I’ve seen many approaches to start-up employee ownership across a broad spectrum of philosophies – from radically low/no employee ownership (beyond the founder/founders) to ultra-high employee ownership (where many or all employees are treated as owners).  At Infinity, we referred to this broad form of ownership as "Citizen Ownership."

I’ve also experienced the best and worst of how ownership can change over time in early- stage companies: from too few people owning too much of a company, all the way to people who contributed little or nothing to the company's success owning a large stake.  In between, of course, is a broad spectrum of ownership, which is where most companies end up.  

I believe that it's very important for founders to (1) consciously and proactively decide up front their aspirational ownership model and (2) plan how to achieve that model using specific corporate and legal mechanisms to execute it.  Don't let your ownership model happen accidentally. This happens - and more often than you would think.

Part of your responsibility as a founder is to protect the interest of early-stage common shareholders from the nature of capitalistic individuals who are not capable of starting companies themselves and/or are just trying to make a $ and don't care about your mission.  If you as a founder aren't looking out for the interest of the common shareholders, it's possible that the people who put in the hard work, sacrifice and commitment to start the company from scratch may be pushed aside by investors or late-comers who desire to capitalize on others' hard work.  

Just to be clear: I’m not advocating that founders be greedy and not share ownership with employees (or investors) who come in at later stages when new skill sets are required.  Quite the opposite: I believe sharing ownership with those who come in later in your company's life-cycle is essential for most entrepreneurs to be successful - I've done this consistently in companies that I've helped start and it has often worked well.  It's critical to embrace the reality that few people are wired like Bill Gates or Steve Jobs and have the skills to lead a company from founding all the way through world domination. 

However, I am advocating that founders be VERY disciplined in ensuring that they protect their own interests and the interests of other early-stage employees, particularly engineers.  If you are successful in your start-up's mission, many people will come along who want to capitalize on your hard work. Sharing your ownership with the right people can create a lot more value as you grow.

So, what's the best ownership model?

Over the past 20 years, I’ve concluded that there is no single ownership model that works broadly across all different types of companies. Founders must match their companies’ ownership models to their management philosophies, as well as their business goals and their expectations for their companies.   

There are as many ways to successfully configure a cap table as there are entrepreneurs. But the end-game configuration that hurts the most is the one where you feel like you've given too much ownership to people who don't deserve or appreciate their ownership in an entity that you started from scratch and that you believed in when no one else did. 

Unfortunately, all too often I see first-time founders accept outmoded or antiquated ownership practices and beliefs that may or may not have worked in another situation/project/company: "In our companies, Founders get X%, Investors get Y%, post-founding employees get Z%."  Often these ownership practices are driven by investors' “models” for how they would like to run their funds: essentially as a series of relatively homogeneous ownership structures that minimize cost and complexity for the fund and help them reduce risk.

I’m not blaming the investors for trying to reduce cost, simplify their businesses and minimize risk.  However, I've observed that often, the most successful companies – those that venture investors strive to fund (call them “The Fundable” ;) ) –  have strong founders who are deliberate in terms of the ownership models that work for them and their new companies. 

The impending Facebook IPO is a strong reminder that founders can and should pursue ownership models that work for them and their companies, regardless of how different it might be from current venture capital ownership dogma.  No matter what investors say, they make all kinds of exceptions to most of their “rules,” all the time.  As a founder, you may or may not have the leverage required to trigger their exceptions. If potential investors say “We never do X,” what they usually mean is “You don’t have enough leverage to make us do X.”

One interesting example of ownership innovation is the “Founder Preferred” model, which has become accepted in Silicon Valley.  Unfortunately, this model has yet to become broadly used in smaller, more provincial markets such as Boston/Cambridge, Seattle and Austin.  It’s hard to believe that such basic practices have not yet been widely adopted, but I hope we will begin to see this happen. 

The recent improvement in the economy has reinvigorated founder confidence, and increasingly founders have the benefit of improved transparency from sources such as “The Funded” and publicly available templates that enable founders to compare deal structures and terms proposed by their potential investors to those of other founders. Let's hope that a successful Facebook IPO will help validate the benefits and integrity of some of these innovative mechanisms that benefit entrepreneurs and thus further encourage even more entrepreneurship/start-ups.  

In my next post, I'll talk about one very important facet of ownership when starting your company: how to optimally structure options grants for early employees.